Wednesday, 26 August 2015

Martin Feldstein on The Unfolding Stock-Market Collapse

The unfolding stock-market collapse—the Dow Jones Industrial Average plummeted
more than 1,000 points on Monday morning, rebounding later to nearly 600 points
down, following several days of decline last week—is the inevitable result of
the Federal Reserve’s policies, namely quantitative easing that produced
abnormally low interest rates. The decline on Wall Street has spread to every
stock market on the globe, many of which were also weakened by their own
policies of excessively easy money...

The increase in share prices took
the price-earnings ratio of the S&P index to about 30% above its historic
average before the market downturn began last week. An alternative measure of
the price-earnings ratio that looks at inflation-adjusted earnings over the past
decade was even higher, at more than 50% over its historic average.

With
virtually no yield available on government bonds and other low-risk fixed-income
securities, investors were tempted to climb on the bandwagon of rising share
prices. Some sophisticated investors realized that the rapid increase of share
prices was a bubble that would end when interest rates returned to
normal....

Though the recent decision to start selling was triggered by
a variety of events, including the collapse of oil prices world-wide and
financial chaos in China, the high price-earnings ratios were enough to make the
downturn inevitable. All that was needed was a spark to start the process, just
as the increased defaults of subprime mortgages did in 2007.

The excess
price of equities was not the only mispricing caused by the Fed’s unconventional
monetary policy. As investors reached for yield in a very low-yield environment,
they depressed the spreads between Treasury rates and the yields on high-risk
bonds and emerging market debt. The prices of commercial real estate have also
been pushed to extremely high levels, driving down yields to unsustainably low
levels. Banks and other lenders have boosted their short-term earnings by
lending to lower-quality buyers and making loans with fewer
conditions.